Sunday, 27 September 2009

A Glimpse of the Monetary Policy (in Action)

Here is a story about the reduction in the Treasury’s Supplemental Financing Program that no one probably read because the few who understood it did not have to read it and the rest would not get it. According to Bloomberg:

The U.S. Treasury Department plans to cut back its borrowing on behalf of the Federal Reserve as it seeks to keep government debt under a legal limit ... The Treasury will reduce the outstanding borrowing in its Supplementary Financing program to $15 billion “in the coming weeks,” the department said in a statement in Washington. The Treasury has been keeping the account, set up last year to give the central bank more flexibility as it undertook unprecedented lending, at about $200 billion.

Note the critical phrase “on behalf” in the opening sentence – the Treasury is planning to cut back its borrowing on behalf of the Federal Reserve. That is an accurate characterization of the program, although the phrase does not appear in the Treasury communiqué that announced the inauguration of SFP. The dreary language of the announcement precludes the use of simple phrases such as “on behalf” and that is a good thing, because the phrase invites inquiry.

What does on behalf mean?

It means that the Treasury is borrowing money not for its own needs but at the instruction, and for the benefit of, the Federal Reserve.

As any loan officer would tell you, that cannot be done; you cannot borrow money on behalf of anyone. In this particular case, there are added complexities.

The Department of the Treasury represents – stands for – the U.S. government in financial markets. Only it, and no other entity, can borrow as, and on behalf of, the U.S. government. That is another way of saying that any borrowing by the U.S. Treasury is, per se, borrowing by the U.S. government, regardless of the intent and the use of funds. You can see this in the Bloomberg story. The Treasury is curtailing the program in order to reduce the U.S. government debt [which was reaching it legal limit of $12.1 trillion]. So the Treasuries issued “on behalf of the Fed” were clearly counted as part of the U.S. government's debt.

But why the need for this arrangement? Can't the Fed borrow money itself?

The answer is, No, it cannot. It is prohibited by law from doing so. Earlier this year it tried to change that law , but ran into opposition and a wall of technical complexities. Some insiders also did not like the idea of the Fed issuing its own debt, but I was enthusiastically for it. I wanted to see how this debt would be priced against the Treasuries.

The Fed, you see, cannot borrow as the U.S. government because it is not the U.S. government – or any part of it. It is not a part of the executive branch. It is not a part of legislative branch. And it most certainly is not a part of the judiciary.

The Fed was incorporated as an entity in 1913. It is comprised of private banks and follows an “independent" monetary policy – independent in the sense that it operates without regards to the economic policies of the government. That is another way of saying that it runs its business as it sees fit no matter who or what party is in charge.

The Fed’s business, among other things, is issuing Federal Reserve Notes, commonly known as money. If you take a bill from your pocket you will see that at top of the side which has the picture of a dead president, it says: Federal Reserve Note. The authority of issuing money and conducting “monetary policy” is vested in the Federal Reserve. The Treasury – that would be the U.S. government – has no say in it.

Why is an “incorporated entity” in charge of the nation’s money supply and monetary policy is a topic for another occasion. We were considering whether the Treasury could borrow money “on behalf” of a non-governmental entity and we saw that the answer was no. The U.S. government could guarantee a borrower – whether explicitly like Ex-Im bank credit lines or implicitly, like old Fannie Mae and Freddie Mac – but it cannot borrow under its name and turn over the funds for the use of others. Yet, as the Treasury secretary, Paulson agreed to this arrangement and Geithner continued with it. Bernanke was not the only one tossing out the rule book.

Why does the Fed which controls money and money supply need the Treasury Dept to arrange borrowing on its behalf?

The answer is that the purpose of the SFP is not so much getting money into the Fed as it is siphoning it out of the system.

Historically, the Fed had strict requirements for the so-called “Fed eligible” securities that the banks could pledge in return for cash. After Lehman, those rules were tossed out and the Fed began taking in junk synthetic securities as collateral that were trading as low as 22 cents on a dollar. However, it accepted them at much higher values than the market, at times close to par, because that is where the banks had financed the securities. If you had $5 and borrowed $95 to buy a $100 security whose price subsequently dropped to $40, you still owed $95. The market did not pay more than $40 for it, but you needed $95. The Fed came in and took your junk for $95. After all that talk, for more than 30 years, about the critical role of the markets in price discovery and fair pricing, the fair market value was likewise tossed out. That was the mother of all rule violations, a replay of the worst excesses of the most unscrupulous mortgage-brokers: valuing the underlying collateral higher than its market price.

In this way, between the summer of ‘07 and January ‘09, the balance sheet of the Fed increased from just above $700 billion to over $2 trillion. The quality of its assets moved in the opposite direction.

The flooding of markets with so much money, above and beyond the value of securities “in play”, risked inflation. To counter that, the SFP was created to take the money out of the system. The Treasury Dept sold Treasuries to take in the money that the Fed had provided to the market in return for junk collateral. Presumably, the monetary policy gurus at the Fed thought that that would be the end of the cycle. But capital is a thing in motion. There is no end point in its circulation. The financial institutions which bought the Treasuries pledged them again with their counterparts for the cash. And the Fed, in order to keep interest rates low and the money flow going, began “quantitative easing”, a code for buying the Treasuries! So, here is the full cycle: giving money away, siphoning it out of the system through the sale of the Treasuries and then introducing it to the system by buying the Treasuries! That is the monetary policy for you.

According to the official statement, the termination of the SFP would have no adverse effects on the Fed actions. The Fed officials stated that that they have other policy levers at their disposal.